Predicting Financial Distress

What is Financial Distress?

Operating cash flows insufficient to satisfy current obligations and the firm is forced to take corrective action Stock-based insolvency
Occurs when the value of assets < value of promised payments to debt

Flow-based insolvency
Occurs when operating cash flows are insufficient to cover contractually required payments.

FIN 551: Fundamental Analysis

FIN 551: Fundamental Analysis

Insolvency
Solvent Firm Insolvent Firm Assets Equity

Stock-Based Insolvency

Debt Assets Debt

Flow-Based Insolvency
$ Negative equity

Contractual obligation Cash flow shortfall Firm cash flow Insolvency

FIN 551: Fundamental Analysis 3

Prediction Models
First stop: Forecast a firms debt rating
Why bother?
S&P rating changes lag

Next stop: Forecast bankruptcy

Altmans Z-score models Emerys lambda index model.

FIN 551: Fundamental Analysis

FIN 551: Fundamental Analysis

S&P Debt Ratings

Median Ratios 1991 - 1993 Pre-tax Interest NWC / Total LT Debt / Coverage debt Total Capital 19.9 8.9 4.7 2.5 1.6 0.7 0.5 136.8% 75.1% 44.3% 29.3% 17.9% 8.5% 1.5% 11.0% 19.3% 30.9% 39.5% 50.5% 58.9% 75.4%

S&P AAA AA A BBB BB B CCC

CCC75.4

% of Public Firms 1.2% 5.4% 16.2% 19.5% 26.1% 28.6% 1.1%

Pre-tax Return LT Capital 24.5% 18.4% 13.7% 9.7% 9.6% 6.4% 5.5%

FIN 551: Fundamental Analysis

Prediction of Debt Ratings

Kaplan & Urwitz Models
Variable Intercept Total assets 1 = subordinated debt; 0 = unsubordinated LT debt / total assets Market model beta NI / total assets market model residual CV in NI (5 yrs.) EBIT / interest Model 1 5.67 0.0010 -2.36 -2.85 -0.87 5.13 -2.90 n.a. 0.007

Coefficients Model 2 4.41

0.0012 -2.56 -2.72 n.a. 6.40 n.a. -0.53 0.006

Predictions Score > 6.76 = AAA; Score >.5.19 = AA; Score > 3.28 = A; Score > 1.57 = BBB; Score < 0 = BB FIN 551: Fundamental Analysis 6

FIN 551: Fundamental Analysis

Predicting Bankruptcy: Altmans Z-Score Models

Private + Non-mfr. Firms
Z = 6.72 * EBIT / Total assets + 6.56 * NWC / Total assets + 1.05 * BV equity /BV debt + 3.26 * Total retained earnings / Total assets

Public Mfr. Firms

Z = 3.3 * EBIT / Total assets + 1.2 * NWC / Total assets + 0.6 * MV equity / BV debt + 1.4 * Total retained earnings / Total assets + 1.0 * Sales / Total assets

Prediction
Z < 1.23 Bankruptcy looming 1.23 < Z < 2.90 Gray area Z > 2.90 No bankruptcy

Prediction
Z < 1.81 Bankruptcy looming 1.81 > Z < 2.99 Gray area Z > 2.99 No bankruptcy
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FIN 551: Fundamental Analysis

ZETA Model
Proprietary model Variables
Zeta is negatively correlated with Barras fundamental betas and Value Lines financial strength score

ROA Standard deviation of ROA over 5 years Interest coverage ratio Retained earnings / total assets (most important) Current ratio Equity / total capital ratio (average 5 years) Tangible assets.
FIN 551: Fundamental Analysis 8

FIN 551: Fundamental Analysis

Keep in Mind
Most prediction models have inherent flaws
Derived on a limited sample Derived for a certain period of time
These problems exist with the bond rating model and Altmans bankruptcy Z-score models

When using the models, ask yourself:

Is the model still valid?

Emerys lambda index model is statistically better.

FIN 551: Fundamental Analysis 9

Emerys Lambda Index

Lambda Index = Liquid reserve + expected CF CF uncertainty
Liquid reserve = Cash + marketable securities + available lines of credit Expected CF = Net cash flow expected to be received or paid during the period CF uncertainty = net cash flow for the period.
FIN 551: Fundamental Analysis 10

FIN 551: Fundamental Analysis

Why the Lambda Index?

Includes cash flows and lines of credit Excludes illiquid items Recognizes uncertainty Although different, its a coverage ratio Provides estimate of likelihood of insolvency.

FIN 551: Fundamental Analysis

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Does It Work?
Results of a test on 52 bankrupt and 52 solvent companies:
Years Before Failure 5 4 3 2 1 Percent Correctly Classified 81% 90% 93% 93% 94% Average Lambda Values Failed Solvent Companies Companies 0.42 4.43 0.19 4.95 0.03 5.46 - 0.66 6.78 - 2.30 9.10

Source: Gary W. Emery and Kenneth O. Cogger, The Measurement of Liquidity, Journal of Accounting Research, Autumn 1982, pp. 290-303.
FIN 551: Fundamental Analysis 12

FIN 551: Fundamental Analysis

Calculating the CF Variables

Actual Actual CF Year Cash Flow Expected CF 1991 $ 69.2 $ - 106.9 1992 729.0 552.9 1993 - 641.2 - 817.3 1994 877.7 701.6 1995 - 154.0 - 330.1 Sums $ 880.7 Expected CF = $880.7 / 5 = $176.1 CF = SQRT($1,586,313.9 / 4) = $629.7 (Actual CF - Expected CF) Squared $ 11,427.6 305,698.4 667,979.3 492,242.6 108,966.0 $ 1,586,313.9
What about deducting necessary investments to maintain competitiveness in markets; i.e., use FCF?
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FIN 551: Fundamental Analysis

Likelihood of Insolvency in 95
Cash & securities 1995 = $952 Expected cash flow = $176.1 of cash flows = $629.7 Lambda = $952 + $176.1 = 1.79 $629.7 Estimated likelihood of insolvency = 1 - N(lambda) Taken from a = 1 - 0.9634 probability table for the normal = 0.0366 or 4%. distribution
FIN 551: Fundamental Analysis 14

FIN 551: Fundamental Analysis

Apples Lambda Using Historical Cash Flow From Operations

6 5 Lambda 4 3 2 1 0 1990 1991 1992 1993 1994 1995

FIN 551: Fundamental Analysis

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Apples Lambda Using Historical Cash Flow From Operations

6 5 Lambda 4
Trend

3 2 1 0 1990 1991 1992 1993 1994 1995

FIN 551: Fundamental Analysis

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FIN 551: Fundamental Analysis

The End

FIN 551: Fundamental Analysis

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FIN 551: Fundamental Analysis